Decisions about who to allocate credit to, and how much credit to allocate, are absolutely fundamental to the path the economy takes in the future.
I’ve used the analogy of stripping an engine to approach looking at the economy. So far, we’ve connected several components – saving, productivity, investment, credit, prices and the money supply – to see how they all interact together, and 2 weeks ago summarised some (hopefully) interesting lessons from this.
The next components we add will be banks and financial assets, but in the absence of these I had to include in the model of Dynamicland a way for businesses to access credit for investment, and for the money supply to be regulated to avoid deflation or excessive inflation. To complete the model I assumed that the the Government extended credit to businesses for investment (using newly printed cash) and then regulated the money supply money by either destroying cash if this credit was causing the supply to increase too rapidly, or printing more money and spending it on public services if the money supply needed to increase further to keep pace with productivity.
This is a very neat model (that’s why I used it), and it does beg the question why doesn’t the system work like this. Indeed, there are those who suggest we should move in this direction. I thought it would be instructive at this point to pause and consider why this doesn’t happen.
The first thing to note is that something like this does exist, at least in extremely rare examples. The state-owned Bank of North Dakota loans to businesses specifically to stimulate the state economy. It is working in practice, and there would probably be value in regional and national governments exploring this model.
So why doesn’t that happen, and why are such examples so rare? I would suggest that the main reason is actually political ideology. Most governments are so wedded to an ideology that states that any government intervention of this type is bad, that they won’t even consider it.
But bear in mind that the North Dakota model is nothing like Dynamicland. The Dynamicland model relies on the Government creating exactly the right amount of new money, and then loaning that money to the right businesses. How would the Government know how much money needs to be created to match productivity? You can’t wait to assess how much productivity has increased, and then raise the money supply – once productivity has gone up, the money needs to be in the economy so that the new goods can be bought. Secondly, when businesses are asking for loans from what is effectively a Government bank, how can the Government know with certainty that the new business is going to work out? What if the technological innovations fail? What if people don’t want the new products? What if someone comes up with a better idea 6-months later and wipes the floor with its competitors? Nothing as neat as Dynamicland could ever work.
But then again, does the current system work, where the creation of the money supply is effectively in the private sector (something I will explain in a series of posts starting in 4 or 5 weeks time)? How do banks know for certainty that a new business is going to work out? This is not just the risk of making a bad loan, it is the risk that credit won’t be extended for good business ideas that will actually increase the productivity of the nation as a whole (a much more pressing issue at this time). How do investors know that their savings are being invested in productive ways? (If you have a pension fund, you might like to ask yourself that question.) What happens when investments don’t make the returns expected, when the economy fails to perform?
I really don’t think I should need to spend any time spelling out the consequence of failed investments or convincing any observant person that the current system doesn’t work either.
What you can hopefully see from this discussion, which builds on everything we have looked at so far, is how critically important are the decisions about how much new money should be created, how much credit should be made available, and to whom it should be loaned. Decisions about who to allocate credit to, and how much credit to allocate, are absolutely fundamental to the path the economy takes in the future. Indeed, it would seem plausible to suggest that this question is central to understanding what is currently going wrong with our economy and how we might put it right. And therefore we should be extremely interested in who gets to make these decisions, and how they make them.
Read that last paragraph again. Make sure you understand it. Very soon we’re going to start talking about what happens in the real world, and this concept is going to be vital.
I estimate 4 or 5 more posts to add banking and financial assets (e.g. stocks and shares) to our model, and then we will look at how money, saving and credit actually operate in the modern economy.